Huawei-Cisco Tests China's Respect for Property Rights

Outcome of court battle could have wide ramifications

A worker at a factory of Huawei Technologies, located in the southern Chinese city of Dongguan, checks an electronic circuit board destined for a communications computer. A row of circuit boards sit upright in the foreground.

It’s been more than a year since China gained entry into the World Trade Organization (Geneva), and now—to take liberties with an English expression—the question is whether its leadership will put its mouth (and muscle) where its money is and enforce rules against piracy of intellectual property.

ncis01.jpg On the streets here in Shanghai, China’s financial center, not much has changed so far: black-market music CDs and movie DVDs sell for 8-25 Chinese yuan (US $1-$3), and the most recent version of Microsoft Corp.’s operating system goes for 40 yuan. Such scenes of small entrepreneurs marketing pirated copies available from countless underground suppliers are found in every city in this huge country. Even with the best of intentions, China’s government will not be able to crack down on this widely dispersed activity any time soon.

But in markets for high-tech hardware, respect for intellectual property may be slowly growing. Foreign companies and organizations like the Business Software Alliance (Washington, D.C.) campaign relentlessly against white-collar piracy. On this front, the most closely watched case is the one launched earlier this year in the United States by Cisco Systems Inc. (San Jose, Calif.) against a Chinese rival manufacturer of Internet routing equipment, Huawei (pronounced Hwa-way) Technologies Co. Cisco alleges that Huawei illegally copied and misappropriated software associated with Cisco networking equipment, including source code and user manuals, and infringed several Cisco patents. Huawei is based in the go-go capitalist enclave of Shenzhen, between Hong Kong and Guangzhou (the former Canton).

Cisco claims that portions of Huawei’s source code are so similar to its own that even text strings, file names, and bugs are identical. Cisco also accuses Huawei of infringing at least five of its patents related to proprietary routing protocols.

After months of denying any wrongdoing, Huawei in late March admitted that an employee had copied 2 percent of the router operating software from Cisco but insisted that the company didn’t know of the violation. In June, a federal judge for the Eastern District of Texas issued a preliminary injunction, barring Huawei from selling products that incorporated the intellectual property in dispute. When a final judgment comes around the end of the year, or if the parties settle in the meantime, what everyone is waiting to see is whether Huawei will live up to the terms, and whether the Chinese government will enforce them by imposing penalties on Huawei, if necessary.

”This is a watershed moment for China Inc.,” says Ross O’Brien, the Asia-Pacific director of market research for Pyramid Research (Hong Kong).

Seeds of a big rivalry

Cisco’s goal is simply to get Huawei to stop its ”unlawful copying” of Cisco’s intellectual property, says Terry Alberstein, director of corporate affairs for Cisco, Asia-Pacific. Although Huawei’s data routing products are only a small part of its business, they earned the company about $170 million in sales in 2002 (out of a $2.54 billion total).

Similar products that Cisco markets in China garnered about four times that much, well over a half-billion dollars. So while Cisco may have trouble collecting damages from Huawei, its position in China is well worth defending. Its larger concern surely is that Huawei soon will challenge it in its core markets in the advanced industrial countries—and may still not play strictly according to the rules.

Cisco faces in Huawei a competitor that has grown fast and furiously. A former People’s Liberation Army soldier founded the company in the southern special economic zone adjoining Hong Kong in 1988 with an initial investment of just a few thousand dollars. In 15 years, the company has rapidly built its business on providing networking hardware for optical, fixed, mobile, and data communications carriers in Asia, Latin America, the Middle East, Europe, and the United States. It has also established research institutes in distant places like Stockholm, Moscow, Bangalore in India, and Silicon Valley.

Despite having more than 22 000 employees now, Huawei has the energy of a start-up, says one of its employees in Shanghai. Taking advantage of China’s lower labor costs and employing engineers for a quarter of what they would cost in the United States, Huawei has been able to undersell competitors in many markets.

Huawei’s latest coup came in March, when it announced a joint venture to develop and market data networking products with 3Com Corp. (Santa Clara, Calif.), the company that commercialized the Ethernet local-area networking protocols. The deal may have been an act of desperation on the part of struggling 3Com, as suggested in some of the business press, but the venture is nothing but good news for Huawei. In fact, it may even help 3Com restore its presence in the data networking products market, says Daniel J. Brody, managing director of the United States Information Technology Office in Beijing.

Already 3Com has helped Huawei in its battle against Cisco. The Texas judge’s June injunction covered only a narrow range of products, and 3Com immediately filed a motion to intervene, asking the court to declare that products produced by the joint venture did not infringe Cisco’s patents. Experts say that 3Com is supplying Huawei with source code to substitute for the code that the Chinese company had been copying from Cisco. While Huawei’s brand might suffer from Cisco’s legal action, ”now they can use 3Com’s name,” comments Allen Chen, a consultant at Norson Telecom Consulting (Beijing).

Striking a balance

By Huawei’s account, 10 percent of annual revenues go toward research and development, which is typical of a company in its position. The question, say some, is how much of that budget goes toward reverse engineering and how much should go to reverse engineering. Craig Watts, a market analyst at Norson, points out that a company playing catch-up with a bigger player needs to put some effort into figuring out how its rival does it. But O’Brien, Pyramid’s market researcher, noting that Huawei has intellectual property of its own that it will have to defend some day, warns that if Chinese companies ”want to be serious international players, they need to generate an appreciation for the rules of the game.”

Firms as diverse as Sony, Adobe Systems, and Unilever have brought suits involving intellectual property against Chinese rivals. What goes for Huawei and similarly situated Chinese companies really goes for the country as a whole. The Chinese government may not enforce intellectual property rules ”to the extent that American companies want them to, but it is in their best [long-term] interest [to do so],” says Grace Chen, an attorney at the Beijing office of Paul, Weiss, Rifkind, Wharton & Garrison LLP (New York City).

The government-controlled China Daily (Beijing) reported on 12 May that the Chinese Ministry of Science and Technology had issued new regulations to Chinese research institutes and technology firms to prevent them from copying products made by other domestic or overseas firms—a common practice in the past. The Business Software Alliance’s Asia branch (Singapore) would like China to go further still, says its vice president, Jeffrey Hardee. Though the situation in China is improving as more companies are taking civil action, Hardee says, his organization is pressing for cases of piracy in China to be prosecuted criminally.

But foreign companies that go to court against Chinese companies must also be prepared to face a backlash. Many of the Chinese media outlets—which increasingly reflect public opinion, rather than just serving as a mouthpiece for the government—leapt to Huawei’s side, declaring that Cisco was trying to block competition.

The government’s favored point of view was well expressed by Zhang Qi, an official at the Ministry of Information Industry, who was quoted in the Guangming Daily News as saying: ”It is not the best solution to go to court. It is best to talk out of court.”